The Corner

This is the second in a two part series on the development of banking in the U.S.

The stock market crash from 1929 to 1932 made a bad banking situation worse. Banks had lent some $8 billion to brokerage houses to finance margin that had fueled the speculative boom. As the effects of the crash spread, banks faced mounting loan losses from both companies and individuals who had borrowed heavily in the 1920s for houses and automobiles.

In the early 1930s, as in the previous decade, the Federal Reserve (Fed) was unable to halt the crisis. Nervous investors created runs on various banks across the country, prompting governors to declare “bank holidays.” The situation deteriorated with reports that Franklin Roosevelt, elected president in 1932, intended to take the dollar off the gold standard. This caused runs on Federal Reserve banks, where people sought to exchange their currency for gold, as well as at commercial banks.

One of the first things Roosevelt did after taking office in March 1933 was to close all the banks for several days and attempt to restore confidence in the banking system. Roosevelt made the first of his “Fireside Chat” radio broadcasts and assured depositors that those banks that were allowed to reopen (thousands weren’t) would do so with an official stamp of approval as to their solvency. The panic subsided, and a later action establishing federal insurance for bank deposits further reassured the public. In the meantime Congress passed emergency legislation taking the country off the gold standard and centralizing gold ownership in the Treasury.

The emergency measure was only the first of a series of legislative actions in the mid-1930s that transformed the financial system. The Glass-Steagall Banking Act of 1933 established the Federal Deposit Insurance Corporation (FDIC) to administer the insurance program and to oversee the financial condition of participating banks. It also prohibited the payment of interest on demand deposits (checking accounts), permitted statewide branching for national banks and mandated the separation of commercial banking and investment banking activities.

The Banking Act of 1935 required state banks with $1 million or more in assets to join the Federal Reserve System. It also broadened the powers of the Fed to regulate bank finances, created an open-market committee in the Fed (which regulates bank reserves through buying and selling government securities) and established the Board of Governors of the Fed, from which the comptroller of the currency and the secretary of the Treasury were excluded.

The periods during and after World War II were ones of much greater stability and prosperity for the banking world. If anything, bankers were cautious to a fault. While the economy was booming and personal income was rising to unprecedented levels, commercial banks focused on their traditional commercial customers.

Most of the new retail business went to savings banks and savings and loans associations after World War II. These thrift institutions originated in the 19th century. The first savings banks were established in Philadelphia and Boston in 1816 in order to promote thrift among the newly emerging working class. The banks saw among themselves as philanthropic institutions helping the poor attain some measure of financial security—if only to have enough saved for proper burial. Savings banks, which as mutual institutions had no stockholders, appear mainly in the Northeast and reached a peak of 666 in 1875.

Savings and loan associations (S&Ls), which originated in Pennsylvania in the 1830s, were patterned after the building societies of Britain. Their members were initially limited to people who wanted to work together to finance the building of a home for each participant, through later they accepted people who simply wanted to save.

In 1932 S&Ls came under the supervision of the newly created Federal Home Loan Bank Board (FHLBB), and two years later their deposits became insured with the creation of the Federal Savings and Loans Insurance Corporation (FSLIC). The benevolent role of the S&Ls was romanticized in the 1946 Frank Capra film “It’s a Wonderful Life.”

By the 1950s the thrift institutions were taking the lead in home mortgage lending, which blossomed after the World War II. The S&Ls alone increased in total assets from $17 billion in 1950 to $129 billion in 1955, at which time there were some 6,200 in number.

The thrifts, however, faced a fundamental weakness in that they tended to use short-term funds to finance long-term loans, usually at low fixed rates. This was no problem as long as the spread between the interest rates on the two (that is, the difference the cost of funds and the rates paid by borrowers) favored the banks. In the 1970s these relative interest rates turned against the thrifts.

Meanwhile the commercial banks had awakened from their slumber. One of the first innovations came from First National City Bank of New York (Citibank) with the introduction of negotiable certificates of deposit in 1961. Comptroller of the Currency James Saxon began liberalizing regulations governing national banks, prompting Chase Manhattan of New York to trade in its state charter for a national one. Fearing a mass defection, state regulators began to loosen up as well.

Other changes of the period included the adoption of computer systems by larger banks and an unprecedented wave of bank mergers. The bigger banks also began expanding their presence abroad, both by entering the emerging Eurodollar market and by following major U.S. corporations to the sites of their foreign investments.

Quote of the Week: “Don’t be overly concerned about your heirs. Usually, unearned funds do them more harm than good.”—Gerald M. Loeb

Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.